David: Hello everyone, thanks for jumping on the call today. Our special greetings to our account holders. It is our endeavor, our goal, through hard work and passion and motivation that we have to build long-term client relationships with you, and we are grateful for the relationships already established and those yet to be established.
I will begin as usual with some general information for those of you who are unfamiliar with Tactical Short. You can find more detailed information at that website, mwealthm.com/tacticalshortTactical Short Strategy.
What is the objective of Tactical Short and the noncorrelated accounts? The objective of Tactical Short is to provide a professionally managed product that reduces the overall risk in a client’s total investment portfolio. We want to do that by providing downside protection in the global market backdrop which we see as having extraordinary uncertainty, and we believe, extreme risk.
The strategy is designed for separately managed accounts. It is very investor friendly, with full transparency, with flexibility, with reasonable fees, and with no lock-ups. We wills short securities, that is, stocks, ETFs. We will also on occasion y liquid list put options, all of those within framework of Tactical Short.
Shorting is a very interesting endeavor. It entails unique risks and we are set apart, both by our analytical framework, and by our uncompromising focus on identifying and managing this. Today’s call will highlight some of the unique aspects of the dynamics we deal with on the short side, and how daily management is required, to both maximize the benefits and also minimize downside for a strategy such as this. We firmly believe that the topping process within the equity markets is unfolding in the markets at present and is one of the more significant tops with a period of volatility ahead of us. I think in retrospect we will see it as one of the granddaddies of a multi-decade period.
What do we do? We tactically adjust our short exposure. We expect to generally target exposure between 50-100% short, and our current short exposure is 65% of account equity. With the market close to record highs and in the face of deteriorating fundamentals, we see extreme market downside risk, but we know better than to try to predict the market, and fully expect an ongoing extraordinary environment with elevated risk on the short side.
Our Tactical Short strategy began Q3 with targeted short exposure of 64%. Exposure was reduced to 60% by late August, and ended September at about 65%. As always, we do not recommend placing aggressive bets against the stock market, but we believe the risk of a market accident is quite high. We have myriad risks, speculative bubbles, market structure, economic risk, geopolitical risks, and all of these demand a disciplined approach to risk management on the short side.
As we often talk about in each of these quarterly calls, remaining 100% short all the time, which is the case with many of the structured products out there for short exposure, is risk indifference, and risk indifference is a problem, especially on the short side in uncertain environments. We structure Tactical Short to ensure the flexibility to navigate through even the most challenging market conditions. We see the cost of a risk-indifferent approach being most apparent here in 2019 and we will talk about this at length today. If you are going to be short, the positions have to be managed. When they are not managed, beta becomes an issue and that is one of the things that we have drawn out in the title of our call today.
So, let’s give you a quick update on performance for the quarter. Tactical Short accounts after fees declined 1.53% during Q3. The S&P 500 was a positive, 1.7%. As for 2019 year-to-date performance, Tactical Short after fees returned -11.98% versus the 20.55% positive return for the S&P 500. Year-to-date through the 3rd quarter, Tactical Short lost 58% of the S&P 500’s total return.
We regularly track our performance versus three actively managed short fund competitors, first the Grizzly Short Fund which returned a positive 1.96 for the quarter. Year-to-date performance, Grizzly has not fared so well. They returned a -19.68%. The Ranger Equity Bear Fund, 3.13 positive for the 3rd quarter, -21.95 for 2019 through 3rd quarter. And then we have Federate Prudent Bear, the Q3 loss was 32 basis points for the quarter, -14.5% year-to-date.
So, on a relative basis, we see Tactical Short has significantly outperformed all three bear funds. Year-to-date Tactical Short, on average, outperformed by 673 basis points, and since its April 7, 2017 inception through the end of September, Tactical Short returned -13.18% versus the 32.59% return for the S&P 500, on average, outperforming our three competitors by 1550 basis points. For the 3rd quarter, Tactical Short, on average, under-performed the three competitors for the quarter by 312 basis points.
I want to transition the call and comments to Doug and he will dig into a little bit more on performance, as well as some of the market structure and fundamentals in the market.
Doug: Thanks David. Hello, everyone. I sure appreciate having you all on the call today. It is always a treat for me to have the opportunity to talk Tactical Short, the markets, and macro-analysis.
So let’s being with performance. I’m a competitive person and I don’t like underperforming competitors, even if it is just for one quarter. But we did lag versus the competing bear funds and I will explain why. First of all, the S&P 500 outperformed the broader market and Tactical Short was short the S&P 500 index. The S&P 500 generally under-performed during the first half, especially during Q1. For example, the S&P’s 13.7% gain lagged the NASDAQ composite 16.8% and the semi-conductors 21.4% advance during that period.
The first quarter also experienced a strong short squeeze with the Goldman-Sachs most short index surging 18.8%, outperforming the S&P 500 by almost 40%. During Q3 most indices under-performed the S&P 500 with the small caps declining 2.4% and the mid caps slipping 0.1%. Yet other sectors like the NYSE Biotech Index dropped 11.9% and popularly shorted stock notably lagged the market with Goldman-Sachs (inaudible) 9:51 5.5% during Q3.
David: Doug, we could have moved out of the index to try to capture some of the under-performance in the broader market. Perhaps you could comment on that.
Doug: Sure, David. That’s a fair question. The short answer is, we could have, but I chose not to because of the ongoing extraordinary high-risk market backdrop. There were major uncertainties associated with ongoing trade negotiations while the Fed and global central banks were pushing monetary stimulus. I continued to see a highly unstable environment with quite elevated risk of abrupt market rallies and intense short squeeze and violent rotations, exactly the type of trading dynamics that make market topping processes such a challenge.
So in such environments, for us, it is fundamental to our risk management philosophy and discipline to diligently manage short portfolio beta for the expected losses that would be suffered under different market scenarios. For example, in the event of bullish market developments, say, positive trade deal headline or tweet, what would be the expected scope of Tactical Short losses in, say, a rapid 5% market advance. I hold the view that the market has been engaged in a prolonged market-topping dynamic and market tops by their nature are periods of major uncertainties and instability, and we have certainly experienced that.
There tends to be heavy shorting, hedging, and derivative activities ensuring an environment susceptible to unpredictable market swings with occasional rapid declines, along with these abrupt market rallies. Sudden, intense short squeezes present a major risk. So in this regard, last week’s market activity was instructive. Positive headlines Thursday and Friday led to a rally, and during those two sessions the S&P 500 gained 1.75%, but one of our competitors lost 3.7% during those two sessions and a second lost 3.11%. The three competitor funds lost, on average, 2.89% or 165% of the S&P 500’s gain. On average, these three funds effectively posted a so-called beta of -1.65.
In an environment where I fully anticipated unpredictable rallies and short squeezes it is imperative to position short exposure to ensure reasonable confidence in our expected portfolio beta. Where I have acceptable clarity in our potential loss-risk parameters, I definitely don’t want to put investors in a position to lose more than twice the S&P’s gain as one of our short fund competitors did last week. And while short stocks, in general, under-performed during Q3 there was a notable short squeeze later on in the quarter.
Thinking back, stocks rallied abruptly beginning on August 28th after President Trump announced the restart of U.S./China trade negotiations. In ten sessions the S&P 500 gained 4.69%, and during this period one of our competitors lost 13.2% and a second dropped to 9.65%. The three competitor funds lost, on average, 9.76%, or 200% of the S&P 500’s gain. As such, on average over this period, these three funds experienced a beta of -2.08.
Over the years I have focused a lot on this upside beta problem, and this is where short positions tend to out-perform the general market while individual positions turn highly correlated. What might have appeared a well-diversified short portfolio rather suddenly becomes a single highly volatile debt against a rapidly rising market, and that is why we focused on the name of this call, Managing Short Side Beta in an Extraordinary Environment.
Over brief periods it is not unusual for short portfolios to upside betas of 2, or on occasion, even 3 or higher. Over that ten-day rally one of our competitor funds experienced a beta of almost -3, and a second was above -2. Over this ten-session period the Goldman-Sachs most short index gained 13.94%, demonstrating an upside beta of 3. Tactical Short was positioned over this period to have a beta below -0.7, losing just over 65% of the S&P 500’s advance. I know these numbers can be a little cloudy, but we lost a fraction of the competitor funds during that rally.
On average, the three competitor funds lost twice as much as the S&P 500’s gain, and in an environment that we fully expect to be highly uncertain and volatile, with these abrupt rallies and intense short squeezes, I don’t want to position short exposure where the probability is high for losing multiples of the S&P 500’s gain during rallies. I am, instead, willing to miss opportunities to ensure we don’t suffer outsized losses.
So why did I stick with a somewhat out-performing S&P 500 short? An important consideration was the extraordinary backdrop that dictated we are going to remain highly disciplined. We are going to adhere to well-defined risk parameters in highly uncertain risk environments, especially when we have suffered losses.
My risk management discipline dictates that we err on the side of caution is something that we take seriously. Such a discipline demands adhering to a low beta strategy, not attempting to pick a market top, avoiding trading an unstable market, staying well clear of short squeezes, and in general remaining patient. My experience informs me that things tend to unfold much more slowly than one would expect. So there are environments in which to be more opportunistic, and environments that beckon for erring on the side of caution. In my view, and frankly, this is where we differ from others, this has been a period to employ well-defined risk parameters.
If we ran a higher beta strategy, a riskier higher volatility short portfolio, that would ensure significantly higher losses during rallies, and one of the challenges of shorting which contrasts with long investing, is that that your positions move opposite to the value of your account. This gets a little confusing, but bear with me here. For example, when the market rises, when short positions are going against me, my short positions grow larger, at the same time that losses reduce the asset value of the short account.
Let’s use a hypothetical example. Let’s say I have a $100,000 account with $100,000 short position. So my account would be 100% short. If the stock market rallies 2%, the short position would increase to $102,000, while the account value would decline by $2000, or 2%, to $98,000. In this example, after a 2% market gain, the account would become 104% short, and that is the $102,000 short position divided by the $98,000 account value. And if the rally continues, the account becomes only more heavily short.
On the flip side, a 2% market decline would see the short position decline to $98,000 while the account value would gain to $102,000, with the account’s short position dropping to 96%, or $98.000 divided by $102,000. On the short side, when the market is rising, the short account is becoming more short, while the account becomes less short when the market is declining. This dynamic makes disciplined active management absolutely essential on the short side. There is no other way to look at it. For the most part, I would prefer not to get increasingly short when the market is going against me, and I’m not happy to be less short when the market is going my way.
David: Doug, is it possible to manage around that challenge?
Doug: Yes, David, and we have to. For starters, we set a short exposure target, and then rebalance exposure to stay near out target. This means that we become incremental buyers when the market is rising, as well as incremental sellers in declining markets. In the above example, if account value drops from $100,000 to $98,000 and our short exposure target remains at 100%, we would buy back a small amount of our short position to reduce the short exposure to target at $98.000. If the market declined 2% we would increase our short position to 102% to get back to the 100% target. We have maintained our short exposure considerably below 100% to help mitigate this rebalancing effort. A short exposure of 65% in the S&P 500, a beta of -0.65, entails less risk of loss, along with reduced rebalancing buying to into a rising market.
High beta short exposure during rallies creates a major predicament. It can be a nightmare. The manager either must buy back significant amounts of stock to maintain an exposure target, or let short exposure mount and hope for a market reversal. I have a cardinal rule when it comes to managing short exposure – avoid outsized losses – so I am no fan of the strategy of letting short exposure rise significantly when the market is advancing. That is a game of Russian Roulette that I don’t want to play.
One of our competitors experienced year-to-date losses as high as 26%, and another 23% so far this year. Those are the types of losses that can mount in a volatile environment when managing short exposure becomes quite a challenge. So when we anticipate major uncertainties and resulting highly volatile markets, as we have experienced both with trade negotiations and monetary policy, we will generally prefer lower beta for our portfolio of shorts.
Others focus on potential opportunities that arise with market volatility and gravitate to higher beta. We focus first on risk, second on reward. Upside volatility means bigger losses that for us would dictate risk control measures, the reversal of short positions into market spikes and we really want to minimize the risk of buying back large amounts of our short positions into spikes, as this negative impacts performance.
Most short products take a different approach to risk control remaining fully short even during rallies, squeezes, and non-favorable backdrops. None of it really matters that much. This does make managing short exposure a lot easier, while opening up the door to large cumulative losses. For us, such losses would be unacceptable.
David: Doug, the focus thus far has been on the S&P 500. Could you comment on that from a fundamental perspective?
Doug: Sure, David. That’s an important point. The S&P 500 companies generate a large share of revenues and earnings internationally, and fundamentally, I have been content to be short an index significantly exposed to global economic weakness and other globalized risks, and less excited to be against the U.S. economy. I hesitate to short some sectors, including the small caps, when financial conditions are loose, or loosening. And as it turned out, junk bonds under-performed investment-grade credit during the quarter, with concerns at the fringe of finance weighing somewhat on the small caps.
I also believe being long the small caps against a short in the S&P 500 was one of the popular pairs trades that stumbled during Q3. So yes, we under-performed our competitors during the quarter. I do regret not having some small cap exposure during the period, although the Russell 2000 had its share of volatility. This index surge almost 5% during the week ending September 13th, versus a 1% gain in the S&P 500.
So the bottom line remains that this is an extraordinarily challenging environment. I have been managing short exposure going back to 1990. I have operated in long bull cycles, as well as bear markets. I have experienced my share of really, really tough market backdrops, but I have never had to navigate through presidential tweets, a U.S./China trade war, or such aggressive monetary stimulus in a non-crisis backdrop.
Think of it – the unemployment rate is, today, at a 50-year low. The economy is growing just below 3%, financial conditions remains loose, markets quite near all-time highs, and yet the Fed is about to cut rates a third time in three months. I’m fond of saying that things turn crazy at the end of cycles, and really crazy during the late phase of historic booms. Well, things have turned really, really crazy.
So let’s wrap up our discussion of short exposure and portfolio composition and our risk focus and then dive into the macro backdrop. As David mentioned earlier, Tactical Short has been in the neighborhood of 65% short in recent months. Exposure was reduced to 60% as the markets rose to all-time highs in late July. But as market trade and geopolitical risks escalated short exposure we took it back down later, but we increased it to 66% in late August before ending the quarter at about 65%. As I have already addressed, it has remained a high-risk environment on the short side, and we have chosen our short target and portfolio composition accordingly, but we also continue to see a market with extreme downside risk, certainly the greatest downside I have seen throughout my career.
With our objective of providing investors downside protection, I have been hesitant to reduce exposure below 60%. I also expect market declines will hit suddenly, providing traders little opportunity to get short. In summary, our strategy has been to provide downside protection while avoiding outsized losses. We have been positioned tactically for what evolved into a prolonged and most challenging market topping process.
Because of the ongoing high-risk environment for shorting, a short in the S&P 500 ETF was the only position during the quarter. While we expect tactically managed listed put option exposure to at times be an important component of our strategy, we again we did not trade an option during the quarter. As I noted during the July call when we began Tactical Short back in 2017, we planned to be patient and disciplined with our put options. I just didn’t anticipate holding off put purchases for this long, and we were again close to buying puts during Q3.
I continue to believe we are heading into what may present itself as an exceptional opportunities to purchase put options in the coming months, but we are going to remain disciplined, and as I mentioned during the last call, I am specifically keen to avoid trading this market, believing a trading-focused strategy would entail too high a probability of disappointing results.
David: Doug, when we look at the macro environment, as you mentioned, a couple of those things which you haven’t seen in previous cycles – the presidential tweets, or an outright trade conflict. Maybe you can give us a little bit of backdrop on an absolutely fascinating quarter from a macro perspective..
Doug: Yes, it sure was, David. The 3rd quarter, just a continuation of this extraordinary market policy economic and geopolitical backdrop we have been dealing with. I can’t imagine a more fascinating environment. I could talk macro analysis for hours, if not days, but for our purposes today I’m going to try to focus on just a few of the quarter’s key developments.
First, the wild and woolly global bond markets. Global safe haven bond markets dislocated, with yield collapsing spectacularly in August. After trading as high as -0.21% in mid July, German bund yields were down to a record low of -0.72% by August 28th, and we had ten-year record low yields, including Swiss bonds, at a –1.20%, and Japanese bonds at -0.3%. And after ending July at 2.01%, ten-year treasury yields sank 51 basis points in a month to 1.5%. Two-year yields recently traded at 1.4%, down from January’s 2.6%. We saw negative-yielding global bonds reach a record 17 trillion in late August, a number that is really hard to fathom, and that is after beginning the quarter at about 13 trillion, and back in January at 8.3 trillion.
So fixed income markets turned manic and buying was indiscriminate. Italian bonds were a case in point. After declining almost 40 basis points during the second quarter, Italian ten-year yields sank 130 basis points during Q3 to a record low 0.82%. Meanwhile, Greek yields dropped 110 basis points during the quarter to a record low 1.35%, and there were 434 billion of bonds issued globally in September. That is an all-time monthly record.
In the U.S. issuance boomed as investment-grade corporate risk premiums dropped to the lows since early 2018 and bonds were certainly responding to expectations for aggressive concerted global monetary stimulus. The Fed cut rates in July and came back and did it again in September. The ECB further reduced negative deposit rates and restarted QE on September 12th. And according to the Financial Times almost 60% of the global central banks reduced rates during the quarter and that is the biggest proportion going all the way back to the crisis.
We saw the Argentina default in August that further rattled markets with contagion spreading to other emerging markets. Fears of a hard Brexit chaos also weighed on sentiment, and the global economy weakened during the quarter, but aggressive stimulus measures were more in response to risks associated with the expanding U.S./China trade war.
There was considerable focus on the Chinese economy throughout the quarter. The quarter began with notable instability in the Chinese money market. Smaller financial institutions lost access to borrowing as fallout spread following the government takeover of Avshon (sp?) bank. Beijing responded with huge liquidity injections. Chinese currency came under heavy selling pressure in early August, dropping over 4% in five weeks as it broke decisively through that key 7% level versus the U.S. dollar. Total Chinese system credit growth slowed markedly in July but then bounced back in August and September. I don’t believe it was coincidence that instability in the U.S. repo market followed by weak Chinese money market instability.
An important theme during the quarter was the heightened instability that began to materialize throughout global finance. Similarly, I don’t believe it was coincidental that the spike in U.S. overnight repo rates erupted a week following an abrupt reversal higher in bond yields, including a notable one-week 53-basis point surge in benchmark mortgage-backed security yields. I’m confident in the view that enormous speculative leverage has accumulated throughout global fixed income markets.
In particular, this year’s spectacular yield collapse that went to blow off extremes during the quarter was surely fueled by speculative leverage and derivative-related buying. The spike in bond prices, a collapse in yields, spur this powerful self-reinforcing buying as the hedge fund community covered shorts, positions long, and those that sold various derivatives against declining market yields scurried to buy bonds to hedge escalating losses on these contracts.
As always, news and analysis follow market direction. The global yield collapsed and the U.S. yield curve inverted and immediately turned its focus to expectations for a rapidly weakening global economy and U.S. recession. Meanwhile, financial conditions loosened, and then when economic data turned more positive in September, the bond bubble was vulnerable. After declining 50 basis points in August, ten-year treasury yields surged 40 basis points in September’s first nine sessions. Globally yields similarly surged. Overnight U.S. repo rates spiked 10% on Tuesday, September 17th and the Fed, for the first time since the crisis, intervened to inject liquidity into funding markets.
And then, after initial efforts failed to return rates back to normal the Fed boosted the size of overnight funding auctions while expanding operations to include 14-day turn repos. In just four weeks Fed credit expanded 183 billion dollars. And then last Friday the Fed announced it would be expanding its T-bill holdings by 60 billion monthly through the first half of 2020, operations that will expand its balance sheet by hundreds of billions.
The Fed is saying it is not QE. Well, that’s just semantics. Analysts blame the spike in repo rates on an unusual confluence of factors, notably the heavy treasury issuance quarterly, corporate tax payments, and the approaching quarter end funding tightness.
David: Doug, don’t you think those are kind of convenient explanations? You mentioned earlier we had a lot going on. The oil markets upset their Chinese credit markets, foreign central banks managing dollar liquidity – the list goes on.
Doug: Yes, that’s right, David. It went way beyond treasury auctions and quarterly tax payments. I viewed repo instability in a very serious light as an indication of systemic fragility. We have seen that in other places globally. And I think we can say it is fair to say the Fed, with their response, has seen things similarly.
I believe a decade of zero and even negative rates, along with unrelenting global QE has fueled unprecedented buildup of leverage, and that is at home and abroad. As I wrote in Friday’s CBB, I suspect the size of carry trades and myriad forms of speculative leverage dwarf those from the mortgage finance bubble area, and having seeped into all corners, nooks and crannies of global fixed income markets. I also highlighted some BIS data and confirm a massive expansion of credit originating from offshore financial centers, most notably the Cayman Islands and Luxemburg.
Also, in my analysis of the Fed’s quarterly Z1 credit data I have highlighted a 700 billion nine-month surge in the Fed’s repo category that I see as corroborating my analysis of a manic speculative melt-up dynamic that tool hold in U.S. bonds and fixed income globally. So I hold this view, and I am confident in the view, that unprecedented leverage, many, perhaps even tens of trillions, have accumulated in U.S. fixed income and Chinese credit, European debt, dollar-denominated bonds globally, and higher-yielding EM debt more generally.
I believe short-term securities, funding markets, and that is both onshore and offshore, surreptitiously became the epicenter for unprecedented leveraged speculation globally. And every time central bankers intervened to backstop market liquidity, they only further emboldened reckless risk-taking and leverage. I fully appreciate how this enormous buildup in leverage speculation works miraculously so long as bond yields are declining, as long a bond prices are rising.
Importantly, uncertainties associated with escalating U.S./China trade frictions, and with it acute risk to fragile Chinese bubbles, spurred a historic global speculative blow-off and bond market dislocation. With global central banks having essentially promised to do whatever it takes to support securities prices bond markets began anticipating aggressive rate cuts in QE. But if only bond yields could fall forever, even as debt and deficits expand uncontrollably.
At this point it is not clear to me how the global system doesn’t turn increasingly unstable, and we have seen plenty of indications of this, which I believe explains why the ECB, and now the Fed, have again resorted to QE. And there has been all of this talk about insurance rate cuts. As central bankers have depleted arsenals, they should use what they have early and aggressively. As the thinking goes, since inflation is low minimal risks are associated with aggressive monetary stimulus, and they are easily outweighed by the obvious rewards from sustained expansions.
This line of thinking is seductive, I will be the first to admit that. Just as inflationism has proven to be throughout history, it is also deeply flawed and dangerous. Central bankers will have less firepower available when they really need it. Yet, that is not the critical issue. Central banks stimulus today is fanning late cycle terminal phase bubble excess. Central bankers will have less ammo later when they confront much bigger crises. Bond market bubbles have succumbed to historic excess and you can see it in the leveraged speculation over issuance as pricing and myriad and other distortions.
Speculative leverage has been stoking global liquidity abundance and the perception of endless market liquidity. Money has continued to flood into bond ETS with scant regard for risk. Equity bubbles have been feeding off of collapsing market yields and loose financial conditions. And in my view we are witnessing a historic global speculative blow-off in financial assets and that is safe haven bonds, equities, fixed income, derivatives, crypt-currencies and the like.
I believe excesses have accumulated throughout international derivative markets, way beyond those from the mortgage finance bubble period. And after this summer’s global market speculative blow-off, fixed income markets are increasingly vulnerable to a destabilizing jump in global yields. I know all the talk is of treasury yields following German bund yields, and Japanese JGB’s much lower. But with deficits approaching 5% of GDP, treasuries are vulnerable to supply and demand dynamics. That is one of the signals being delivered by upheaval in the repo market.
One of the major costs of QE and whatever it takes central banking has been a complete breakdown in fiscal discipline. The current complacency regarding spiraling federal debt recalls the lack of concern for mortgage excesses during the previous bubble period. Rapidly inflating quantities of credit of deteriorating quality at rising prices is unsustainable.
I hold the view that the global financial system is now highly vulnerable to a bout of de-stabilizing, de-risking, de-leveraging. During Q3 we saw cracks in Chinese money markets, EM bonds, U.S. overnight funding markets, and global bond market instability more generally. Beijing has once again prodded their banking system into aggressive lending. Meanwhile the ECB and Fed have again resorted to liquidity injections. Central to my analysis, such measures work only to extend the cycle that speculation, leveraging, resource misallocation and economic maladjustment.
It is also worth noting that despite generally strong markets, performance issues have been impacting segments of the leverage speculating community. There was the August default in Argentina where contagion effects were reverberating through key emerging bond and currency markets. Some speculators were caught short treasuries during the melt up, others were whip-sawed by extreme yield volatility. There were also the previously discussed short squeezes and a so-called quant quake back in early September. Long/short strategies in particular were hit hard during a violent sector rotation.
Some sizable funds have performed quite poorly in 2019, and internationally they have been a few large funds suffering through acute illiquidity. These types of performance issues are a characteristic of market tops with poor performance quietly working to reduce risk tolerance, boosting the odds that risk-off de-risking, de-leveraging dynamics take hold in the event of a market downturn. I currently don’t have a strong view on the stock market for Q4. I believe there has been significant hedging ahead of recent trade talks for now. It appears the most feared outcome may have been avoided.
It is not clear to what degree the unwind of hedges could fuel equities, or if a rally might incite animal spirits and anticipation of a year-end rally. But I do believe global fixed income is vulnerable here. Credit has been expanding robustly in China which for now supports their historic bubble and it would be atypical for the U.S. economy to succumb to recessionary forces in the face of such loose financial conditions. Markets have priced in ongoing aggressive monetary stimulus while the major central banks face growing internal dissent.
We will see if the FOMC is really determined to cut rates again with trade tensions easing and stocks near record highs the market currently has an 83% probability of a Fed rate cut at the end of the month. That is a very high number considering the less dovish views of many on the committee. If we are at the cusp of a trade truce and a Fed on hold, I would see bond markets as highly vulnerable. The long list of risks to the great bull market seem to only expand. Market dynamics, speculative leverage, the global economy, monetary policy, China, the impeachment inquiry, geopolitics, the coming election cycle to name the more obvious. I believe global markets have been signaling trouble ahead. It should be another fascinating quarterly for analysis and a challenging environment in the markets.
I will conclude this segment noting the sudden travails and afflicted the IPO marketplace during Q3, one more indication of the shifting liquidity and market backdrop, where we work, it has been one rather precipitous fall from grace from Wall Street darling to fighting for survival in a span of a few short weeks. It is a timely reminder of how things change when a high-flyer loses access to cheap finance. I expect we work to prove a harbinger of things to come. After a decade of the most egregious monetary stimulus imaginable and an awful lot of uneconomic enterprises proliferating in the U.S., China, and globally, it makes for an interesting environment. The tightening of financial conditions and waning liquidity will come with major ramifications for markets, economies and geopolitics, and not for one minute do I believe central bankers have things well under control.
David, back to you.
David: Doug, a part of the we work dynamic is a shift in sentiment. If you look at the market of the last 30 years, or just go back 30 days ago, the market was content to pour billions of dollars into profit list story stocks. Imagine how they are going to disrupt and change the world of tomorrow. And at that point they were capturing the investment community’s imagination with sort of unbounded pro forma potential. And yet in the last month something shifted.
Doug, as you are often referencing a tightening in financial conditions as a critical indicator, wouldn’t you say that the shift in recent weeks in the IPO market is a form of financial tightening? Even here amongst Silicon Valley venture capitalists who in recent weeks are describing the current environment as ominously familiar like the 2000-2001 period where the investment spigots just got turned off.
Doug: Yes, that’s right, David, I agree, ominous parallels to the waning days of the tech bubble. But this also reminds me of the summer of 2007, or at least so far, probably more than 2000-2001, that bubble deflation, as you recall, back in middle 2007, City Group’s Chuck Prince famously quipped, “We’re still dancing.” Yes, the bubble was inflating, Q&A was hot back then, debt issuance, private equity where booming. The economy was strong.
But there was, below the surface, a subtle shift unfolding. The marginal mortgage borrower was losing access to cheap finance. Few appreciated it at the time but the great mortgage finance bubble was faltering. When subprime derivatives and securitization markets stumbled in the summer of 2007 the marginal home-buyer lost access to affordable mortgages, home prices began to falter, lenders became nervous, buyers pulled back, the bubble began to deflate. Stocks went to all-time highs in the fourth quarter of 2007.
Not appreciated at the time was the role that speculative finance and leverage had played during the bubble and how that associated liquidity that the purchasing power from the mortgage finance bubble had come to play such a dominant role in both the securities markets and the overall economy. And yes, David, as you were saying today we are seeing in what I will call subprime business like we work, and we can certainly throw in the shale operators. They have begun to see less availability of cheap finance.
And this is how it starts, the subtle turning of the cycle. Now the marketplace will look to see who else could be exposed to the changing landscape and there is suddenly a renewed interest in balance sheets and cash flows, and that is after a decade when they haven’t mattered. Well, they are going to start mattering.
I look at tech and software, energy, media, telecom, biotech, and a number of other sectors as having been operated in, in this arms race dynamic. Why not just throw money at any opportunity? But we are now at the early stage of a tightening of financial conditions at the margin. For companies that have operated at the fringe of financial viability, we are seeing effects. And I believe we are only a market break away from this dynamic expanding to more of a 2000-2002 scenario. And I will add to the current tech bubble that a global scope so far behind the late 1990s. I have said that the current environment has ominous parallels to 2007, early 2000, and the 1998 global crisis.
David: One of the things that stands out, I know our focus is 3rd quarter and some of the things that have transitioned here in the 3rd quarter, but backing up a little bit, even looking at buyout deals, there has been a shift there, too. Again, we’re talking about changes at the margins, 2014-2018, your buyout deals globally were just escalating year after year after year. Relative to 2018 we are now down almost 20% in terms of deal flow. It is one of those fascinating things, you begin to see changes at the margins.
I have a list of questions here from clients and folks who would like to get to know the program a little bit better. I’m going to start with one for you, Doug. It says:
I am just looking to learn about your strategy on protection against future market conditions. Which sectors are you focused on taking an inverse or non-correlated position? Are you long in any sectors in this strategy? I have liquidated all of my equity positions at this time. I am long real estate, treasury bills, cash, physical gold and silver, and I hold inverse S&P, NASDAQ and Russell 2000 positions. I am looking to better understand how and why the Tactical Short might be good for me.
Doug: Yes, that’s a good question. Depending on the environment, we are very focused on what a particular environment is that we’re operating in, we will short stock sectors, market indices. As we mentioned before we will trade listed put options. We’re not long. There may be an environment in the future where we could have some activities on the long side. We’re not long today. We want to have as many tools in the toolkit as possible and at times we used them more defensively, and at other times more opportunistically. But as I discussed earlier, right now we’re short the S&P index because of this extraordinary environment and our focus on risk control.
Could we help this person who is managing different short positions? My first question would be how comfortable are you managing your short exposure as I’m sure you realize it presents quite a challenge and in difficult environments, and I speak from experience on this, it definitely can impact one’s mood, sleeping pattern, and even outlook on life. So I would like to think we could bring our experience and insight and make your life easier.
Managing short exposure, especially in volatile markets, tends to be all-consuming. Most people grow tired, weary, frustrated with the experience, and over the years I’ve always tried to dissuade individual investors from doing their own shorting. Most go into it not appreciating the risks and operational challenges.
So I would say, if you really enjoy managing your short exposure, and feel comfortable that you can effectively manage the risk you can avoid paying us or others a management fee, but for most I believe management fees are a small price to pay on the short side for the peace of mind of professional expertise and management.
David: Doug, the next question is:
Is it practical for an individual investor to be able to take a short position using ETFs?
Doug: Yes, it is practical. There are a variety of ETFs that are negatively correlated to both market indices as well as individual sectors. It is also possible you can short ETFs. That what we do in Tactical Short. But being repetitive here, I just think individual investors should think twice before they take the plunge into shorting. The double and triple inverse short ETFs are dangerous, especially in volatile markets. Even in bear markets you get these 10% and 20% rallies that can inflict heavy losses in these levered ETFs.
I spoke earlier about our focus on beta, the thought of being 200% or even 300% short on index or a sector is crazy to me. So if one is compelled to be short the market I would strongly suggest a low-risk strategy with well-defined risk parameters. That is how we try to play it, at least in this environment. Since I think it presents a major challenge for folks with limited experience managing short experience, I recommend just staying away from shorting unless you have seasoned professional management.
What are the possibilities that a new QE program, perhaps even the one that was just announced by the Federal Reserve, will be able to provide the necessary liquidity for renewal within the equity markets?
Doug: Right. That’s a key question. We don’t have answers and we are going to have to follow developments very closely to make a judgment on that. I mentioned before that I believe unprecedented leverage has accumulated in global securities markets, perhaps in the tens of trillions. So in that context the Fed’s 60 billion monthly T-bill program is rather small. And also keep in mind that Washington will be running 100 billion monthly deficits now for as far as the eye can see.
We also know some key foreign holders of treasuries, notably China. They have stopped buying and have even become sellers, so I don’t look at the Fed’s latest program as having that much firepower. Just over recent weeks we have seen it take about 200 billion of Fed balance sheet expansion just to stabilize overnight funding markets. In the event of a serious bout of de-risking, de-leveraging, it will take hundreds, perhaps trillions of Fed purchases to accommodate speculative de-leveraging.
And keep in mind, that the original 1 trillion Fed QE program had little actual impact on marketplace liquidity. It essentially was just a transfer of securities from leveraged players to the Fed’s balance sheet. I look at the Fed’s latest QE as important evidence of mounting underlying system fragility, and candidly, from the perspective of someone managing short exposure, it is good to get some of these rate cuts and QE announcements out of the way. That said, Fed operations, along with the semblance of a trade deal, that increases the odds of a speculative run into year end, so I have to factor that into our risk-reward calculus.
David: This question is from Dale. He says:
You evidently believe the Tactical Short strategy can keep an overall portfolio safer. What evidence is there in terms of performance or results, and how much does it cost in terms of performance? Thank you for the opportunity to learn what you are doing and how it might help me.
Doug: Yes, and thank you, Dale, for that question. It gets right to the heart of really important issues and considerations for investors. As we mentioned earlier, David specifically, the objective of Tactical Short is to provide a professionally managed product that reduces overall risk in a client’s total investment portfolio while providing downside protection in a global market and backdrop fraught with risk. So there are different ways to look at this and the associated costs.
We recommend Tactical Short as an allocation within a broad investment portfolio strategy, and a lot of times we will say anywhere between 5% and 20%, depending on the environment, depending on that portfolio, the investor’s risk profile and tolerance. We are trying, here, to provide a hedge, market protection, against bad income, and bad outcomes. The market is near all-time highs. There has been a cost in holding this hedge while other components of an investment portfolio have hopefully performed exceptionally well. If an allocation to Tactical Short has allowed investors to stick with their long investments, they have done fine. If an allocation to tactical short has helped investors avoid selling other instruments, it may have been part of an effective tax planning strategy.
We are convinced markets today are at extreme risk. I believe it is time to mitigate risk, which may include hedging strategies. I believe Tactical Short provides a cost-effective alternative to many of these other hedging strategies that have suffered big losses, that perhaps don’t manage risk as well as we do. There will be huge losses of wealth in the next bear market. Those that effectively mitigate risk, hedge some of this risk, will be better able to weather the storm. So we hope we can talk to you more about what we do, Dale.
Dear David and Doug. With a new round of QE, without naming it so, wouldn’t it be appropriate to dial down the short exposure close to zero and wait for the credit expansion to revert, i.e., a credit contraction? Thanks, and good luck.
Doug: This is the key debate, the key analysis for us. We’re looking at a lot of different indicators. I call it a mosaic of indicators. I believe the latest round of QE is confirmation of the underlying fragilities that have become acute in the U.S. and global. It is confirmation of our analysis that we are really, really late in the game here, that the Fed has been forced to do these things so quickly and with market at all-time highs.
Global markets have been flashing warning signals over recent months. That certainly includes collapsing bond yields, the surging gold price that we haven’t mentioned, money market instability in the U.S. and China, so I believe I would be doing Tactical Short investors a disservice by not fulfilling our mandate if I took short exposure to zero.
Candidly, I would be content to somewhat reduce short exposure today if I believed I could get it back on in a timely manner before a major market decline, but it is the nature of today’s global market structure that I fully expect the market to drop so abruptly that few will be able to get short into a downside market dislocation. We have seen indications of this and I just believe that is the way it will play out. Moreover, if you short aggressively when it already appears the market is breaking down, then you take the risk of getting whip-sawed by rallies. So this is part of the market challenge and there are frankly no easy solutions.
David: The next question is:
With Powell expanding its balance sheet, not calling it QE, and QE meaning more liquidity and equally higher stock prices, why have higher weightings in shorts? Do you expect stock prices not to go up on QE?
Doug: This is kind of similar to previous questions. Let me add to my comments here. At this point, I look at this Fed move more in terms of accommodating de-leveraging rather than boosting marketplace liquidity, and this is a very important distinction as far as market dynamics and market risk/reward. But I will be closely monitoring the bond and funding markets to discern liquidity effects. I stated I believe the Fed’s balance sheet will likely inflate to 10 trillion during the next crisis and down cycle, and I just basically assume that the Fed’s balance sheets will have to more than double again. It is has doubled in the past, it will have to double again.
The Fed and global central bankers will have no alternative then to expand their holdings and monetize debt, but I believe this is all quite negative for financial assets. It is recognition that central bank policies have failed to foster sound markets and economies. Note that the Fed doesn’t want their program called QE. They would prefer not to go back there, just as they don’t want to have to take interest rates negative. So they are doing some things to support funding markets but I don’t expect them to take more significant leaps into unorthodox policies until there is a systemic crisis.
The problem is markets have already built in quite aggressive monetary stimulus. We see that in the bond markets, Fed fund futures, and all of these indicators. Markets are ahead of the Fed at this point, yet monetary stimulus is not the bid story right now, it is this escalating risk of global de-risking, de-leveraging, and how this year’s stimulus measures have only extended this dangerous cycle of speculative leveraging and market bubbles. I think history will not be kind on this aggressive stimulus.
I believe the amount of speculative leverage continually outgrows the capacity of central banks to manage a de-leveraging event. If the Fed wants to add some liquidity then the leverage is going to increase multiples of that for problems later. But in the near term we will be closely monitoring market dynamics, liquidity conditions and policy moves. We have no choice.
How do the varying prospects for the presidential candidates figure into your strategy? How do you filter out the short-term noise?
Doug: I’m going to use the fascinating word again because the fascinating election cycle is, along with the fascinating monetary policy and the fascinating bond collapse – everything is fascinating. So there are a lot of moving parts here, and first of all, we have to see how this impeachment inquiry unfolds. The Democrats have to pick their candidate. There is even talk that Michael Bloomberg could enter the race if Joe Biden falters. We could get surprising twists and turns along the way, third party candidates, etc.
Right now it is more noise than anything else, but it seems likely that we will see candidates with polar opposite extremes on key policies, so that essentially means a lot of uncertainty, market volatility, for the next year. I have a hard time believing it will be anything other than a lot of uncertainty and volatility. The president’s election prospects could hinge on the performance of the markets, and that also adds an additional layer of complexity to this analysis.
David: This question for Dan on economic status quo:
What is holding this economic status quo together? What might trigger a cusp event? Thanks.
Doug: Thank you, Dan. I will answer this from my particular analytical perspective. I focus a lot on credit, liquidity, market dynamics and right now credit has been expanding. Markets are near all-time highs. Financial conditions are generally – and I will say generally – quite loose. The household sector has never enjoyed such gains in perceived wealth, so they continue to borrow and spend.
In short, the bubble continues to inflate the economy and when bubbles inflate, the economy appears relatively sound, but the situation changes profoundly in the event of a market downturn and tightening of financial conditions. We saw a hint of this again last December. Scores of companies struggle to raise funds in that environment. Businesses will pull back and investment households will suffer negative wealth effects and will borrow and spend less. This can unfold quickly.
To make matters more concerning, there are today global fragilities that we didn’t have back in 2008 so today’s status quo is vulnerable to a lot of developments. As far as a trigger, any number of things could hit market confidence and incite the cycle’s long overdue downside. I put China and global bond markets at the top of my list of potential catalysts, but it is a long list, and sometimes bull markets just succumb from exhaustion. So we still have to wait to see how this plays out.
David: A question through that online portal – James, a good friend of ours who knows a thing or two about derivatives and structured products. This is for you, Doug:
What development would motivate a substantial reduction in the existing short position, 20% or more? What development would motivate an increase in the existing short position by 20% or more?
Doug: I will start with taking 20% off, which is not a low probability scenario. Let’s say we make a decided move to new highs in equities, and we don’t see a bond market sell-off, we don’t see higher yields in that scenario. If we don’t see tighter financial conditions in that scenario, we will be cutting back short exposure in that environment. 20% is very reasonable.
What would cause us to increase 20%? If we see an expansion of this dynamic we have seen at the fringe of a tightening of financial conditions, if I see my mosaic of indicators start to indicate tightening, especially in the investment-grade corporate debt market, if we started to see illiquidity in global markets and certainly, let’s say, big outflows from investment grade fixed income ETFs in particular, if we started to see the hedge funds on the wrong side of a number of trades, if we started seeing de-risking, de-leveraging from the hedge fund community – again, we have seen hints of that, we’ve seen a little bit at the fringe – if we started to see that gather momentum, then that profoundly changes the risk/reward calculus in the marketplace and we would want to be more short.
I anticipate that we could increase our short exposure by 20%, but I think part of that 20% would be through listed put options, which would give us downside protection, or downside opportunities with our put options, with limited risk. But we could in that environment definitely take our short exposure up 20%. We are a little bit here – I hate to call in no-man’s land, but we’re in the middle of that – where we are seeing indications of risk-off. We’re seeing a lot of vulnerability. We’re seeing at the fringe tightening of financial conditions, we’re seeing at the fringe hedge funds with some performance issues, but we need to see it – they call it contagion – we need to see it start to expand.
And if we started to see Chinese policy-makers lose control of their financial instability that would be another important indication. China continues to be the big wild card here. It is a little bit off the headlines right now, but that is a very unstable financial system, a very unstable economy, that now only functions with rapid credit growth. That rapid credit growth is going to bite them. It’s just a matter of time.
David: Well, we have gotten through most of the questions. I want to thank everyone for joining us. A surprise we didn’t have any questions on metals on this particular call, even though the 3rd quarter was quite a spectacular move higher in that area.
I want to mention just one thing. As we have restructured our MAPS (sp?) portfolio strategies in the 3rd quarter, Doug’s insight is being used to, at least with two of the four strategies, bring an active management function to the short positions that are there, to act as a hedge. Those are our four hard assets portfolios, and for those of you who are interested in learning more about that, you can join myself, join Lila Murphy for the conference call October 31st. And again, we get the benefit of Doug being in-house to help with the Tactical Short, or the equivalent of it, that overlay within those hard asset portfolios.
For those of you who are interested in perhaps just trying to learn more about the Tactical Short, as I mentioned at the beginning of the call, you can go to mwealthm/tacticalshort and learn some more details. A next step is looking at our ADV and management agreement and kind of looking under the hood and saying, “All right, so I think I understand it conceptually, what are the inner workings here? How does this function on a day-to-day basis?” If you want that under-the-hood view, then by all means, request the ADV and the management agreement and that will, I am sure, stir some questions for us to follow up and continue the conversation with you directly.
I appreciate the opportunity to share these ideas with you, as does Doug and the whole team, and we look forward to serving you in any way we can, as an existing client, or if you are considering this as an addition to your portfolio management structure. With any questions, feel free to write them and send them in, or give us a call. We can set up a time that is agreeable for you and explore all the points of curiosity you may have. Thanks so much for joining us today.
Doug, any last-minute comments?
Doug: Thanks for joining the call today, and good luck everyone. Thank you.